Blog

Social networking for exchanges

Primary exchanges around the world that fail to meet the needs
of institutional investors face an increasing risk of disintermediation by
newer, smarter platforms that do.

With exchanges everywhere focusing on reducing latency and
improving their capacity in recent years – witness Singapore Exchange’s new
Reach platform launched in August, the London Stock Exchange’s
Millennium Exchange platform introduced in February 2011 and Brazilian exchange
BM&F Bovespa’s ongoing Puma upgrade – conventional wisdom has it that speed
is king.

But these improvements are merely reactive. They are not innovation. And it can be argued they fall far short of meeting the real
needs of long-term investors. Like a chess player continually reacting to his
opponent’s last move, exchanges are simply copying innovations introduced by rivals. This places them in grave danger of missing the bigger picture and
spotting opportunities of their own.

One of the biggest potential opportunities is helping the institutional
investor trade in blocks. As markets have become more fragmented in recent
years, it has become increasingly harder for long-term investors to trade large
blocks of stock. Instead, orders are divided between multiple brokers, further
divided between different trading platforms and dark pools, and then subdivided
by algorithms into child orders. The end result is that the available portion
of liquidity at any one place and time is becoming extremely limited.

The ‘race for pace’ may have resulted in fast but dumb
matching engines that have jettisoned flexibility in the quest for all-out
microsecond latency. But as trading becomes faster, concerns over
high-frequency trading in lit markets have helped fuel a flight of
liquidity to dark pools. Both in North America and in Europe, trading
figures show dark pools achieved their highest-ever market share in the
first two months of this year. High risk of information leakage on the lit
markets, together with smaller and smaller fills, recently led one senior
buy-sider trader to tell The TRADE that the lit book is now “literally the last
place you want to go.”

Broker crossing networks offer a tiered system, in which users
are grouped according to category. Tier one might consist of electronic
liquidity providers, while tier two flow might be largely provided by other
brokers’ algorithms. Users can decide with which tier of flow they are
willing to interact.

Buy-side preferences suggest the emergence of Facebook-style
trading platforms, which can bring that kind of control to the lit markets.
Market participants will be able to use social networking-style rules to expose
their orders only to the specific subsets of the market with which they wish to
interact. Adding order types that are not accessible to high-frequency
traders, for example, could provide a ‘safe’ environment where institutional
investors feel secure enough to post large blocks of liquidity.

Meanwhile, for all their past enthusiasm in principle for
the lit markets, regulators are not necessarily as supportive of tailored
platforms provided by exchanges as might be thought. Far from supporting their
attempts to develop alternative platforms of their own, aimed at different
market segments, the US Securities and Exchange Commission has – according to
some press reports – launched an investigation into whether such platforms
might favour larger firms at the expense of smaller ones.

While such a concern is valid, it does threaten to undermine
the opportunities to follow multi-platform strategies pursued by exchanges such
as TMX in Canada, which launched TMX Select in July as a platform specifically targeted
at high-frequency traders, or the Australian Securities
Exchange, which in summer 2010 adopted a block trading platform called VolumeMatch. But if regulators really want to stem the flow of liquidity into dark
pools, perhaps they should work more closely with exchanges to develop
attractive alternatives.